Best Execution Practices Face Pressures
September 13, 1999
Regulators, competition and technology are starting to put pressure on mutual fund companies to examine what they pay broker/dealers in commissions for their funds' trades.
An SEC fact-finding examination of trading practices, the use of electronic communications networks, or ECNs, for trading and competition ultimately may help reduce the expenses funds incur to buy and sell stocks, according to mutual fund executives and regulators. That scrutiny of commission costs seems likely to increase in the coming weeks.
The SEC is expected to sue two investment advisers in separate cases over their alleged failure to obtain the best execution of their trades, according to sources familiar with the cases. SEC lawyers expect to bring one case this month, sources said. It was unclear what firms the SEC will sue. SEC officials declined to comment.
The planned enforcement actions come as SEC examiners are visiting mutual fund companies as part of their efforts to learn about the companies' efforts to obtain the best execution of their trades. SEC officials expect to complete the fact-finding exams this year. The likely outcome of the SEC's exam is unclear, said Chris Ullman, an SEC spokesperson.
So far, however, the SEC has found that fund companies are using ECNs for trades, said Gene Gohlke, associate director of the SEC's Office of Compliance, Inspections and Examinations. The degree of use varies from firm to firm among those the SEC has questioned, Gohlke said.
The use of ECNs should help reduce trading costs. ECNs are trading systems that match buyers and sellers of stocks electronically, without going through traditional brokers. ECN commissions run from approximately one to two cents a share, fund executives said. The broker/dealers who historically have executed mutual fund trades on average charge institutional customers such as funds 5.5 cents to six cents a share for the trades they execute, fund company executives said.
Despite ECNs' lower costs, many fund companies have been reluctant to use them for a significant percentage of their transactions. The networks often do not have the liquidity to handle large buy or sell orders, unlike the New York Stock Exchange or NASDAQ, executives said. Funds also receive research or assistance in fund distribution when sending trades to some broker/dealers. Those arrangements can be useful for funds, executives said.
American Century Investments of Kansas City, Mo., has been a big proponent of ECNs, and is conducting about 30 percent of its fund trades through the networks, according to company executives. In June, American Century took a five percent indirect stake in an ECN, Archipelago Holdings LLC of Chicago. (MFMN 6/21/99)
Pressure from regulators and mutual fund boards of directors will help stimulate the use of ECNs in the fund industry, said Michael Cormack, manager of equity trading for American Century. That pressure could grow even greater if market performance drops and investment returns suffer, Cormack said. Fund companies, facing scrutiny from shareholders over performance in a down market, will look at trading expenses as a way to cut costs, Cormack said.
There is evidence that fund companies already are paying attention to trading costs and making their efforts known to investors. In a prospectus it filed with the SEC on Aug. 13 for two new funds, Zacks Investment Management of Chicago explained in detail its plans to use ECNs and other trading strategies as part of its efforts to closely monitor trading costs. Zacks executives with knowledge of the matter were not available for comment.
Industry observers, however, said the level of detail in Zacks' disclosure was unique. Disclosure in fund filings about execution practices has been essentially unchanged for nearly 20 years, said Pamela Wilson, a lawyer at Hale & Dorr in Boston.